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What Are You Weighting For?

All too often it seems advisors zero in on an investment theme
and choose the largest or most liquid ETF in that segment without
regard to the underlying index strategy. Those days should be over,
because it's pretty clear that not all index methodologies are
created equal.

Looking at the slew of available ETFs that canvass the financial
sector in a recent two-year period, we examined how the performance
of funds tracking the same segment was affected by the methodology
used to select and weight constituents. Between December 2008 and
December 2010, Rydex's equal-weighted index strategy and First
Trust's Intellidex index markedly outperformed the rest of the
group.

And the biggest of the group, a market-cap-weighted offering
from State Street Global Advisors, got outperformed by a
revenue-weighted ETF from RevenueShares that also has a large-cap
tilt. The only fund that SSgA's Financial Select Sector SPDR
(NYSEArca:XLF) beat was an ETF from PowerShares that uses a
one-tiered-weighted index.

In short, making relatively minor tweaks to the same universe of
stocks can produce a wide array of return patterns and risk
exposures. An equal-weighted strategy will likely outperform a
traditional market-cap portfolio in a rising market where growth
companies outperform value. However, alternative weighting
strategies tend to be more expensive than cap-weighted strategies,
accelerating tracking error.

All of these nuances point to an undeniable conclusion:It's high
time that advisors and investors in general understand that
different weighting schemes yield different returns and, crucially,
a bit of homework will make sure investors know what they're
getting into.

How A Weighting Strategy Impacts Costs

To compare how the various index methodologies performed
relative to each other, we chose one fund to represent each
weighting methodology. The funds and their index strategies
are:

PowerShares' Dynamic Financial Sector Portfolio
(NYSEArca:PFI), based on a proprietary index that uses growth and
value metrics to rank companies, and then weights them
equally

First Trust Financials AlphaDEX Fund (NYSEArca:FXO), based on
a proprietary index that uses growth and value metrics to rank
and weight constituents from the large-cap Russell 1000
Index

RevenueShares' Financials Sector Fund (NYSEArca:RWW), based
on a revenue-weighted index

To minimize the influence of factors other than weighting
methodology, whenever possible, we focused on funds whose
constituents were pulled from the same universe.

State Street's XLF, Rydex's RYF and RevenueShares' RWW each draw
their components from the financial sector of the S&P 500,
while PowerShares' PFI and First Trust's FXO have broader selection
universes.

It's no accident that XLF, at 0.20 percent a year, is the
cheapest of the funds we surveyed, as the fund's underlying index
is taken exclusively from the S&P 500 and has a large-cap tilt.
It's also the largest ETF in the group, with $7.85 billion in
assets, giving it economies of scale that enable SSgA to run it
more cheaply.

RYF and RWW, meanwhile, cost twice as much as XLF even though
they pull securities from the same universe, providing clear
evidence that tweaks to weighting strategies can have a significant
impact on trading costs.

In fact, all funds employing alternative-weighting strategies
have expense ratios that are more than twice that of XLF. That's
tracking error that takes away from their returns.

What's Behind The Performance Deviation?

The tilt toward relatively smaller-cap companies in an
equal-weighting methodology, such as in Rydex's RYF, exposes a
portfolio to higher-beta financial firms whose returns outpaced
those of larger, more diversified financial firms in the period of
study.

To be precise, small-cap financial firms had little to no
exposure to European sovereign debt issues, and were therefore
insulated from the large sell-off last summer.

However, the PowerShares PFI had the worst performance during
the period. On the surface, that might seem surprising, because PFI
uses a variation of equal-weighting, and thus shares the
smaller-cap tilt of the simply equal-weighted RYF.

That underperformance can be explained by the fact that although
PFI employs a modified equal-weighting methodology, the index's
proprietary ranking system resulted in a fund that had a 75 percent
value bias, and a weighting toward insurance firms that was well in
excess of either FXO's or RYF's.

As the chart below shows, PFI's portfolio has a price/earnings
ratio that's less than half that of RYF. It's this clear contrast
in style tilts and sector weightings that drove the wedge between
the performance of PFI and that of the two other leading
equal-weighted funds in the segment.

Banking

Insurance

Investments

REITs

Real Estate Operations

Non-Financials

XLF

48%

24%

18%

4%

2%

4%

FXO

18%

46%

18%

7%

4%

7%

RWW

46%

40%

11%

1%

1%

1%

RYF

29%

27%

22%

9%

2%

11%

PFI

22%

56%

15%

0%

3%

4%

Interestingly, the revenue weighting strategy of RWW caused the
ETF to tilt larger than even the market-cap-weighted XLF. Again,
size tilts don't tell the whole story, as the fund had a slight
growth bias relative to XLF, which, as we've seen, performed better
in the period studied.

The table below reveals that the equal-weighting strategy of RYF
produced the group's best "information ratio," a measure of
risk-adjusted returns. RWW managed to post the second-best
risk-adjusted returns of the group, reinforcing the idea that
simple tweaks to the same universe can enhance performance given
the ideal market environment.

FXO

PFI

RWW

RYF

XLF

Information Ratio 12 months

6.738%

2.925%

7.001%

12.396%

2.009%

P/E Ratio

15.81

12.03

18.32

25.82

16.80

Average Market Cap ($US M)

$12,624 M

$10,449 M

$83,635 M

$23,108 M

$80,200 M

On the other hand, the relatively low information ratios of XLF
and PFI reveal the weaknesses of the two funds' weighting
methodologies. The large tilt of XLF exposed the portfolio to the
largest multinational banks in the segment. It was in the past two
years that these banks had to deal with both the fallout from the
subprime crisis and the European sovereign debt mess.

Since the period of study was one filled with such unique
market-moving events, it's difficult to draw any concrete
conclusions about how different weighting methodologies will impact
performance moving forward. Only time will tell.

But for now, if the market keeps rising and growth continues to
outpace other investing styles, simply equally weighting your
portfolio will help you reap outsized rewards.

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